8. Forward Exchange Rate | |
Definition | Forward exchange markets deal in promises
to sell or buy foreign exchange at a specified rate, and at a specified
time in the future with payment to be made upon delivery. These promises
are known as forward exchange and the price is the forward exchange rate.
Forward exchange markets do not operate during periods of hyperinflation.
The forward exchange market resembles the futures markets found in organized commodity markets, such as wheat and coffee. The primary function of forward market is to afford protection against the risk of fluctuations in exchange rates. |
when forward markets are active | Forward markets are most useful (i) under flexible exchange rate system and if there are significant exchange variations, (ii) under fixed exchange rate system, if there is a strong possibility of devaluation/revaluation, |
Non operational | (i) it cannot function when exchange control is imposed. (ii) it cannot function during periods of hyperinflation. |
10. How to avoid foreign exchange risk | |
Enter Forward market | You may enter the forward exchange market. As long as the return from overseas investment is greater than the domestic return, one would sell forward pound (or whichever currency in question). Only when the forward transactions are made, the risk can be avoided. However, avoiding the foreign exchange risk may be too costly, in which case it is not profitable to avoid the risk. |
(i) If F = $1.47, then St=90 = 686.667 x 1.47 < 1.02 million. You are worse off. Even if i* > i, do not invest in the UK. (That is, taking the foreign exchange risk is cheaper) (ii) If F = $1.53, then St=90 = 686.667 x 1.53 >1.02 million. You are better off. Invest in the UK. (In this case, forward transactions are profitable and eliminate the foreign exchange risk.) |
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Investing in NY | If one invested A dollars in New York, then at the end
of 90 days, the return will be (1) A(1 + i) i = i90 = annual interest rate ÷ 4. However, the subscript 90 is suppressed (too cumbersome) |
Investing in London | If one invested in London (by buying pounds in the spot
market, and selling pound forward, the investor can cover against the exchange
risk (interest arbitrage) (2) A(1 + i*)(F/S) F = price of one pound sterlilng for delivery 90 days hence S = price of one pound sterling in the spot market |
Equilibrium forward rate? | Interest arbitrarage will cause the forward rate to adjust
to the interest rate differential until it reaches an equilibrium rate.
This equilibrium rate F is determined by (3) A(1 + i) = A (1 + i*)(F/S). Solve for F. (4) F = S(1 + i)/(1 + i*). Since i and i* are small fractions, this is approximately equal to: F = S(1 + i - i*), or i - i* = (F - S)/S. |
Intuition | That is, if the domestic interest rate is higher, the forward pound must be sold at a premium. Specifically, the domestic interest advantage (i - i*) must be equal to %premium on the forward pound when the forward rate is at its parity. For example, if the domestic interest is 1% above the foreign interest rate, forward pound must be higher than the spot rate by the same proportion to prevent capital flows. |
11. Covered Arbitrage Margin | |
Covered arbitrage margin | (CAM) = (i - i*) - (F - S)/S. |
When capital inflow | If i - i* > (F - S)/S, then K* inflow occurs. (Domestic investors have no incentive to invest abroad, but foreign investors will invest in America) |
When capital outflow occurs | If i - i* < (F - S)/S, then K outflow occurs. (Foreign investors will stay put, but domestic investors will move funds abroad) |
Remark: If i = i*, there is no incentive for any investors
to move funds between countries, except for the forward premium. In this
case, if F > S, domestic investors would make money by selling forward
currency and invest abroad. As a matter of fact, if the forward premium
is sufficiently large and more than offset the possible interest loss (i
- i* > 0), one could invest overseas. If i - i* = (F - S)/S, then no capital flow. |
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Interest parity | Let Fo be the rate at which no capital flow
occurs. If F = Fo, then the forward rate is at its interest parity.
Federal Reserve Bulletin publishes CAM, e, i, i*. CAM are very nearly zero. |
Interest rate parity | |
Problems of IRP Theory |
Keynes' theory does not take into account differing investment risks between the two countries. (1) Interest rates in developing and transition economies are generally higher, due to higher risks. (2) Inflation rates also differ between countries. It is not the nominal payoffs, but real interest rates. Thus, different inflation rates will affect investment decisions. |
Currencies of the World, Pacific Exchange Rate Service